Many traders across the globe take advantage of the head and shoulders pattern to help them predict future market behavior. The ultimate goal of any trading endeavor is to be ahead of the game. When you know how the price will behave in the future, you will be able to invest your money wisely in a profit-generating move.
The head and shoulders pattern is often seen on trading charts exhibiting three peaks. In its primary sense, this pattern indicates trend reversals and further helps to give critical trading signals. Because they are widely used, budding traders are required to have a good grasp of what the pattern indicates.
The head and shoulders pattern is a valuable trading tool, and this article will break down various aspects surrounding it. Afterward, you will have a thorough understanding of the pattern, when to implement it and ultimately be able to trade using the head and shoulders pattern successfully.
What is the head and shoulders pattern?
This pattern is represented by three peaks appearing on a baseline along the price line. The middle section is usually the most prominent as the lesser pair located on either side of it. The center peak is called the head. It is flanked on either side by the right and left shoulder.
The baseline from which the head and shoulders pattern arises follows an asset’s price. This value will rise to the first peak, decline and rise once more to a second peak. The second peak is positioned above the initial one forming a ‘nose.’
After hitting its highest summit, the price will then decline to the original base point from which it will climb up for the final time. This time, it will only reach the initial height before receding to the base.
Inverse head and shoulders pattern
An inverted head and shoulders pattern is known as a head and shoulders bottom. The shape of this pattern is the opposite of the regular head and shoulders configuration.
As such, the price initially dips to a trough, then rises before declining past the initial trough. Once again, it will emerge from this low-point and rise again. Afterward, it will fall and form the last trough. Once this is done, the price leaps upwards.
Features Of A Head And Shoulders Pattern
The head and shoulders pattern is a distinct shape that forms on a trading chart. There are several key features that such models display, and these are critical to interpreting the trading signal that follows.
It is the first peak that forms as the price line fluctuates between subsequent bottoms and peaks. By definition, the left shoulder is situated on the left side of the central summit, the head. The left shoulder comes about after the rise in price terminates in a peak before falling.
After the price falls from the first peak, it rises anew to the highest level yet. This new peak is the head and towers above adjacent summits.
This is the last peak formed from a declining price movement that eventually rises but doesn’t reach the height seen on the middle peak. This diminished summit is the right shoulder.
The neckline is a crucial line on the head and shoulders pattern which traders use to inform their next trading move. It is often gotten once you have identified the other three critical features of this pattern, the head, left shoulder, and right shoulder. The neckline then comes about from the left shoulder and head of the head and shoulders pattern.
So first, find out the lowest points of the price line as it drops from both the left shoulder and the central head. The connection between these two points now forms the neckline. It is typically marked by a horizontal line cutting across the price line.
The neckline is crucial to trading this pattern. For instance, no trading should take place until the complete head and shoulders pattern manifests. So once the trend goes past the neckline, then it is all systems go.
Identify The Head And Shoulders Pattern On A Trading Chart
The head and shoulders pattern is a pretty straightforward illustration on a trading chart. Here is an example with a neckline crossing its length.
Trading The Head And Shoulders Pattern
Since traders often use this pattern to make trading decisions here are a couple of essential items you should know before you get started:
The ultimate destination for any uptrend is a reversal. So, as a rule of thumb, an extended uptrend will eventually lead to a significant reversal. The right shoulder, the final piece of the puzzle, signals an impending reversal in the market. Once this segment begins to form, you can start plotting the neckline.
The head and shoulders pattern shows how buyers are behaving in the market. In this case, a diminished shoulder signals a trend that is losing momentum. So as a trader, it is best to prepare for a potential reversal in the market.
Moreover, you need a neckline in place to actually confirm a trend reversal. Once the price crosses your neckline, then the head and shoulders pattern is complete. A lot of traders only use the right shoulder to confirm this pattern.
However, the right shoulder is just a single facet that tells you a reversal is in the offing – it hasn’t occurred just yet. A trend technically breaks once a peak that is lower than the prevailing highs forms. Hence the reason many traders mistake the right shoulder for an indication that the pattern is complete.
Distinguishing an already formed pattern from one that is still in the works is the first step to trading using the tool.
Let us now consider your market moves following the head and shoulders pattern. Different traders use a pair of distinct trading strategies. In the first method, you don’t have to wait for the market to close below the neckline. On the other hand, you can play it safe by waiting out the market until it closes below the neckline.
This is the riskier of the two entry methods you can use to trade a head and shoulders pattern. With this, you are going to wait for the price curve to cross your neckline. This way, you will be able to test out the neckline as a resistance point.
By testing the neckline, you can ascertain whether the uptrend has run its course and a reversal is in the works. A neckline that doesn’t hold points to a sustained uptrend and the head and shoulders pattern anticipated hasn’t formed.
Remember, always wait for the pattern to manifest before trading. The neckline should give you a clear indication of this.
While this method guarantees a much higher success rate, you can wait for a move that won’t happen. Since you are waiting on the neckline to manifest as resistance, once the pullback ceases and the breakout resumes, you will have missed a trading opportunity.
If you can stomach a little risk, then consider the second method. First of all, wait for the candle to close below the support then sell. There isn’t much to this method, but the risk of the scenario being a false break. False breaks are frequent when trading high-frequency timeframes such as on an intraday basis.
Risk management determines, to a great extent, whether a trade will be successful or not. Even if a move looks promising, you need to watch your profits, and in case things don’t go your way, your earnings are still safe. So it is essential to mark out your stop-loss placement.
Usually, traders place their stops at two common points. The top of the right shoulder is preferred over using the pattern’s head as a stop.
Additionally, you can place your stop after the right shoulder. Ideally, it should lie just above the last summit following the right shoulder.
Setting profit targets
Your profit target from the head and shoulders pattern is obtained from the difference between the head and lowest point of either shoulder. Once you get this figure, subtract it from the neckline breakout so that you get the target on the lower end.
If you have an inverted pattern, the difference gotten from the head and shoulder lows is added to the neckline break so that you get a target on the higher level.
Significance Of Head And Shoulders Pattern
The head and shoulders pattern, like many other trading tools, isn’t entirely foolproof. However, in theory, this pattern should tell you when to enter or exit a market with some degree of conviction.
Falling prices indicate a favorable buying environment, and buyers are slowly getting into the market. Once you get to the neckline, those who bought on the rally in the right shoulder have their expectations quashed and are facing a loss-making scenario. They will inevitably exit the market, further driving the price toward your profit target.
Additional guidelines for trading the head and shoulders pattern
Make sure the pattern forms after a prolonged uptrend. Make sure that there are no swing highs after the potential left shoulder.
The shoulders should lie below the head’s maximum point. Following this structure, you should be able to make out the head and shoulders pattern from afar quickly.
The neckline is a critical aspect of this pattern. Therefore, make sure it is always horizontal or moving up. Stay away from a pattern with a descending neckline because a falling neckline signals a weak reversal pattern. You can still make something from the situation, but the risks involved don’t warrant the move.
Timeframes matter when it comes to trading. In the case of this pattern, shorter timeframes yield much better results, such as daily and weekly intervals. If you go lower than this, your pattern will exhibit many false positives.
Limitations of this pattern
- Trading this strategy requires that you wait for the pattern to manifest itself fully. If you aren’t patient, this trading method will fail. Additionally, if you trade on a partially formed head and shoulders pattern, you run a higher risk of making losses as oppose to waiting out the trend.
For novice traders, this pattern requires a bit of practice to be able to spot on a price line.
- Fundamental information plays a crucial role in your decision to enter or exit a market. This way, any sudden event may force the price to drop further than anticipated. Eventually, you will be unable to hit your price targets following this significant drop.
- Price action plays a vital role when interpreting the head and shoulders pattern. As such, newbie traders might find it challenging to read a price action that is retesting the neckline. This scenario could also lead to missed trades once you decide to wait out the trend.
- Also, the head and shoulders pattern can be subject to individual interpretation. Different traders will view them differently depending on the trading style in use. It is prudent to have a clear definition of what an ideal pattern ought to appear before pinpointing one.
The head and shoulders pattern is frequently used by traders to generate decent profits. While this pattern may seem like a straightforward tool, there is a considerable amount of analysis that has to be done so that you can yield successful trades.
To interpret the head and shoulders pattern, you have to first figure out what is going on behind the scenes. Consider the buyers and sellers who are causing the price to shift. Also, check out the prevailing market environment as well to get a better understanding of the forces that determine the cost of assets.
While it is not a surefire means to achieving trading success, following the laid out guidelines will guarantee you a degree of profits from your trades. Since this method analyses the technical aspect of trading, you also ought to deliberate the fundamental side of things to get a clearer picture of the prevailing market condition.